Revenue Recognitions For Development Project

Revenue Recognition For Project DevelopmentThe process and methodology of revenue recognition for development project depend on the type of project. The revenue recognition for sale of condominium units is very different from that for the sale of an office building or apartment building after they are built, for example. It is also different from the revenue recognition of the rental of any office or apartment building.

Examples of rental properties include office space, residential apartments, retail shopping centers, warehouses, and hotels. Revenues from the rental of spaces from these types of properties are not recognized until the projects are substantially completed and held available for occupancy. A project is defined as substantially complete and held available for occupancy when the developer has completed tenant improvements but no longer than one year after major construction activity has been completed.

Profits and revenues from sale of real estate are accounted for in various ways, depending on the nature of transaction. The six most common methods of revenue and profit recognition are: (1) Full accrual method (2) Deposit method (3) Installment method (4) Reduced-profit method (5) Percentage-of-completion method (6) Cost recovery method.

This post discusses these types of projects and the revenue recognition methods.

 

Generally accepted accounting principles (GAAP) require that revenue should be recognized when earned. The revenue from a month-to-month rental of a space is recognized when the rent is due from the tenant. However, for long-term leases (leases for periods over one year), GAAP requires that the revenue should be recognized on a straight-line basis unless another systematic and rational basis is more representative of the beneficial usage of the leased property.

 

 

1. Full Accrual Method

The full accrual method is one of the methods of real estate profit recognition in which the full sale price and profits are recognized when the real estate is sold. For the full accrual method to be used, the transaction has to meet two main conditions:

  • The profit can be reasonably determined.
  • The seller’s obligation to the buyer is complete.

 

The profit from the sales transaction can be reasonably determined if there is reasonable assurance that the sales price of the transaction is collectible from the buyer and any portion of the sale price that is not collectible can be reasonably estimated.

If the two criteria are not met, the seller has to determine which other methods would be appropriate.

However, in addition to the two main conditions noted above, a transaction has to meet these four additional criteria:

  • Criteria-1. A final sale between the buyer and the seller has been consummated such that all the obligations between the parties have been fulfilled and all conditions prior to closing have been met.
  • Criteria-2. The buyer has sufficient initial and continuing investment in the transaction to demonstrate its ability and willingness to fulfill its obligation. This ensures that the buyer has enough skin in the deal to avoid backing out of the transaction. The buyer can meet this requirement by providing enough down payments, an irrevocable letter of credit from an independent financially viable lending institution, or full payment of the asset’s purchase price.
  • Criteria-3. In cases where the buyer did not pay for the purchase price in full at the time of closing, the remaining amount due to the seller is not subject to any future subordination after the sale. This also means that in the event of default by the buyer, none of the buyer’s debt obligations would have preferential claim on the property higher than the seller’s claim on the property.
  • Criteria-4. The sale transfers all the rights, risks, and rewards of ownership of the property to the buyer. The seller should not have any substantial remaining obligation to the buyer in relation to the sale. An example would be a development project where the completion and delivery date is still in the future. In this case, the seller still has substantial remaining obligation to deliver a completed premises to the buyer at a future date. Thus, the full accrual method would not be used in recognizing the total profit.

 

If it is determined that the transaction meets the criteria for full accrual method, the entry to record the transaction by the seller (e.g., the sale of a property for $20 million) would be:

[Debit]. Cash = $20,000,000
[Credit]. Sales = $20,000,000

 

Initial Investment Criterion 2 above requires that buyer has sufficient initial investment in the transaction, so for the buyer’s initial investments requirement to be met, GAAP provides that the initial investment shall be equal to at least a major part of the difference between usual loan limits for that type of property in that market and the sales value of the property.

GAAP also requires that for recently obtained permanent loan or firm permanent loan commitment for maximum financing of the property, the minimum initial investment by the buyer should be whichever of the following is greater:

a. The minimum percentage of the sales value . . . of the property.

b. The lesser of:

  • The amount of the sales value of the property in excess of 115 percent of the amount of a newly placed permanent loan or firm permanent loan commitment from a primary lender that is an independent established lending institution.
  • Twenty-five percent of the sales value. It is important to note that the initial deposit used in the analysis of minimum initial investment is the nonrefundable part of the deposit if the agreement has a refundable deposit clause.

 

Continuing Investment

In addition, criterion 2 for use of full accrual method requires that the buyer has sufficient continuing investment in the transaction. Continuing investment relates to the buyer’s payment of the remaining purchase price after the initial investment in the transaction.

The Statement of Financial Accounting Standards No. 66, paragraph 12, says:

The buyer’s continuing investment in a real estate transaction shall not qualify unless the buyer is contractually required to pay each year on its total debt for the purchase price of the property an amount at least equal to the level annual payment that would be needed to pay that debt and interest on the unpaid balance over no more than (a) 20 years for debt for land and (b) the customary amortization term of a first mortgage loan by an independent established lending institution for other real estate.

 

In other words, after the buyer makes the initial investment in a real estate purchase, the remaining amount due to the seller, which in most cases is financed through an independent lender, should at a minimum have financing terms as mentioned. This criterion is viewed as an indication of the buyer’s ability to acquire the assets and also fulfills the borrower’s obligations on the transaction.

Case Example

A condominium unit purchased as the buyer’s secondary residence is sold for $1 million, and the buyer provided an initial deposit of $150,000. Assume in this example that the loan for the remaining balance of $850,000 was from an independent established lending institution.

To determine if the $150,000 initial deposit is sufficient to establish the buyer’s commitment using the minimum initial investment criteria, this analysis should be performed.

Analysis:

(a) Minimum percentage of the sales value per-
Minimum Initial Investment Table (10%)          = $100,000

(b)(1) Sales value in excess 115% of –
loan ($1,000,000 – ($850,000 x 115%)            = $  22,500

(2) 25% of the sales value ($1,000,000 x25%)  = $250,000

In this analysis, the required minimum initial investment should be $100,000. This amount is determined by first calculating (a), then obtaining the lesser of (b)(1) ($22,500) or (b)(2) ($250,000). The minimum initial investment is the greater of (a) ($100,000) and (b) ($22,500).

 

 

2. Deposit Method

The deposit method is one of the methods that can be used when a real estate transaction does not meet the conditions and criteria required for the full accrual of profits. Under this method, no profit, receivables, or sales are recognized; however, the seller can disclose in its financial statements that the asset is subject to a sales contract.

This method is used to record the initial and continuing investments in a real estate transaction made by the buyer prior to consummation of sales. The deposit method is also the appropriate method of accounting for a transaction where the recovery of the project’s cost, in the event of the buyer’s default, is not assured.

Examples of real estate transactions where the deposit method may be used are:

1. The sale has not yet been consummated; thus the deal has not yet closed, or there are remaining obligations between the parties required before consummation that have not been fulfilled.

2. The buyer meets all the criteria for the full accrual method except that the initial investment and the recovery of the project’s cost cannot be assured if the buyer defaults.

3. Condominium projects where one or more of the four criteria required for the percentage-of-completion method (PCM) has not been met. (See the discussion on the ‘‘Percentage-of-Completion Method.’’)

4. A real estate transaction where the seller guarantees a return on the investment for a limited period of time. The agreed-upon costs and expenses incurred prior to the operation of the property should be accounted for using the deposit method. However, if the guarantee is for an extended period, the transaction should be accounted for as a financing, leasing, or profit-sharing arrangement, depending on other specific terms of the transaction.

At closing, when all the conditions required for consummation of sale and full accrual are met, the seller would then recognize the sale with this journal entry:

[Debit]. Deposit liability = $1,700,000
[Credit]. Sales = $1,700,000

This entry reduces to zero the liability that has been recognized from the prior deposits received by the seller and also recognizes the sale as a result of the transfer of the risks and rewards of the asset from the seller to the buyer.

In this exercise we focus on the revenue-related journal entries. Note, however, that other journal entries would have to be recorded to recognize the related cost of sales, which prior to now were being capitalized as work in progress (WIP).

Assume that the total cost of the unit sold to the plastics company was $1 million. This amount, which was recorded when incurred as WIP, will be recognized in the income statement as cost of sales with this entry:

[Debit]. Cost of sales = $1,000,000
[Credit]. Work in progress = $1,000,000

This entry should be recorded at the same time as the total sales is recognized. In essence, it matches the cost of sales with the related sales recognized.

 

Case Example

Lie Dharma Construction Corp., a developer of industrial warehouse and manufacturing facilities, is developing an industrial park built-to-suit. A start-up plastics manufacturer signs a contract to purchase one of the 20 warehouse units at the park at a purchase price of $1.7 million. Prior to the signing of the sale agreement, the buyer provided the seller deposit money representing 10 percent of purchase price. Assume that the sale has not been consummated and the seller has determined that in an event of default by the buyer, the cost of the property would not be recovered due to reasons such as property location or design uniqueness. In this type of situation, when the seller collects the 10 percent deposit, the amount should be recorded by the developer as a deposit with this journal entry:

[Debit]. Cash = $170,000
[Credit]. Buyer deposit liability = $170,000

Any subsequent continuing investments by the buyer would be recorded with similar entries as above until sale is consummated and the ownership rights, rewards, and obligations pass to the buyer.

 

 

3. Installment Method

The installment method is the appropriate method where both:

  • A transaction would have qualified under the full accrual method except that the buyer’s initial minimum criteria were not met; and
  • The cost of the property could be recovered by reselling the property in the event the buyer is not able to fulfill its obligation under the terms of the agreement.

 

Under the installment method, each payment made by the buyer to the seller is allocated between cost and profit using the same ratio by which total cost of the project and total project profit is proportional to the sales price.

 

Case Example

ABC Corp. sells a property to XYZ Corp. for $2 million. XYZ paid a cash down payment of $100,000 with the remaining balance financed by ABC Corp. For purposes of this exercise, it is assumed that the buyer’s initial investment did not meet the initial minimum criteria and therefore will be accounted for using the installment method.

Based on the above information:

Total sales price = $2,000,000
Total cost           = $1,200,000
Total profit         = $   800,000

Profit % = 800,000/2,000,000 = 40%

 

At the time the sale was consummated, ABC will record the sales, the gross profit that was deferred, and the total cost of the sale with this entry:

[Debit]. Cash = $100,000
[Credit]. Accounts receivable = $1,100,000
[Credit]. Sales = $1,200,000
(To recognize sales, cash receipt, and receivables)

[Debit]. Cost of sales = $1,200,000
[Credit]. Real Estate Property = $1,200,000
(To recognize related cost of sales and remove assets from books)

[Debit]. Deferred sales profit = $440,000
[Credit]. Deferred assets from uncollected receivables = $440,000
(To recognize deferred receivables; amount is determined as: 40%  x $1,100,000 = $440,000)

 

As more of the receivables are collected from the buyer, the seller will recognize the deferred profit from the sale. Assume that the next month XYZ remitted the contracted monthly payment of $50,000; the entry to recognize this receivable and the related deferred profit would be:

[Debit]. Cash = $50,000
[Credit]. Receivables = $50,000
(To record the receipt of the receivables)

[Debit]. Deferred assets from uncollected receivables = $20,000
[Credit]. Profit recognized = $20,000
(To recognized the prior deferred profit; 40% x $50,000 = $20,000)

The income statement of ABC Corp. immediately after this transaction would look like this:

Revenues:
Sales                                 $ 2,000,000
Deferred profit                      (440,000)
                                         $ 1,560,000

Costs:
Cost of sales                        1,200,000
                                            
Net income                       $     360,000

 

 
4. Reduced-Profit Method

In the discussion on the installment method, we mentioned situations where a transaction meets all the criteria for full profit accrual except that the initial investment criteria were not met. The reduced-profit method is similar to the installment method. The reduced-profit method of profit recognition is used where all the criteria of full profit recognition are met except that the continuing investment criteria were not met.

However, for profit to be recorded using this method, the annual payments by the buyer should at least equal:

  • The interest and principal amortization on the maximum first mortgage debt that could be used to finance the property; plus
  • Interest on the difference between the total actual debt on the property and the maximum first mortgage debt.

 

Remember, the criterion to meet ‘‘continuing investment’’ is that the buyer is contractually required under the debt agreement of the total debt on the property to pay each year an amount equal to at least principal and interest payment over the customary amortization term of a first mortgage loan by an independent reputable lending institution. For a land purchase, the appropriate payment period is determined to be 20 years.
Case Example

An office property located in downtown Houston, Texas, with cost to seller of $15 million was sold for $20 million. The buyer paid a down payment of $3 million and obtained a $14 million first mortgage from an independent lending institution at a rate of 10 percent over 20 years. In addition, the seller provided a second mortgage financing to the buyer of additional $3 million with interest of 8 percent over 25 years. The interest on both loans is compounded monthly.

Assume that the down payment of $3 million is the minimum initial investment requirement and that the customary first-mortgage financing for this type of property in this market would be over 20 years with a market rate of 11 percent.

On this transaction, since the second-mortgage financing by the seller is for 25 years (which is above the term to meet the continuing investment criteria for this type of property), the total profit of $5 million that should have been recognized at the time of the sale is reduced, and the deferred profit is recognized from years 21 through 25.

The calculation is determined as:

Total sales price       = $ 20,000,000
Total cost to seller   = $ 15,000,000
Total Profit               = $   5,000,000

 

As mentioned, the total sales price is comprised of:

Buyer’s deposit                                        = $    3,000,000
First mortgage from independent lender  = $ 14,000,000
Second mortgage from seller                    = $   3,000,000
Total sales price                                        = $ 20,000,000

 

The buyer’s monthly payment based on the terms of the debt agreement on the $3 million second mortgage is calculated as:

Loan amount                             = $3,000,000
Term in months (25 yrs x 12)   = 300
Rate                                           = 8%
Monthly payment                      = $23,001

Therefore, the present value of the $23,001 monthly payment for 20 years would be:

Monthly payment                                        = $ 23,001
Market rate                                                  = 11%
Customary market term in
months (20 yrs x 12)                                    = 240
Present value                                                = $ 2,248,799
Deferred profit ($3,000,000 – $2,248,799)  = $     751,201

The profit recognized at the time of sale would be:

Sales price                                    = $ 20,000,000
Cost                                              = $ 15,000,000
Deferred profit                             = $      751,201
Profit recognized at time of sale  = $   4,248,799

 

So, in years 21 through 25, the deferred profit of $751,201 would be recognized as the mortgage payments are recovered. The straight-line method (or another reasonable method) can be used in recognizing this deferred profit from years 21 through 25.

 

 

5. Percentage-Of-Completion Method

The percentage-of-completion method is a revenue recognition methodology in which revenues and profits are recognized as construction progresses if certain specific criteria are met. This method is used mostly in condominium and time-sharing projects, where the units are sold individually. For a project to be recorded using the percentage-of-completion method, five criteria must be met:

1. The construction project has passed the preliminary stage. The preliminary stage of a project has not been completed if certain elements of the project have not be completed, such as surveys, project design, execution of construction and architectural contracts, site preparation and clearance, excavation, completion of foundation work, and similar aspects of the project. These criteria are some of the basic requirements before a percentage-of-completion method can be used in accounting for a condominium or time-sharing project.

2. GAAP requires that the ‘‘buyer is committed to the extent of being unable to require a refund except for non-delivery of the unit or interest.’’ The determination of whether the buyer is committed to buy the unit or interest requires judgment; however, one way to make this determination is to utilize the minimum initial investment criteria. It is important to understand that the purpose of determining the buyer’s commitment is to ensure that the buyer has more skin in the transaction and prevent the buyer from easily walking away at any slight change in the market. The minimum initial investment requirement provides a guide that can be used to determine the buyer’s commitment in the transaction.

3. The project should have sufficient units sold to ensure that the project will not regress to rental. Obviously, the percentage-of-completion method is used to recognize revenue and profit while the project is still ongoing based on the assumption that the units will be completed and sold to buyers, not rented to tenants. This criterion ensures that the objective is achieved. To prevent the possibility that the developer, after recognizing some revenues and profits related to the units sold, then reverts the project to a rental property, the developer is required to sell sufficient units before using the percentage-of-completion method. The determination of how many units are sufficient requires significant judgment, but the decision must be made based on the nature of the project, the market for that particular type of project, and the local and regional economy where the project is located.

4. The agreed-on sales price of the units of interest should be determinable and collectible. The collection of the sales price can be assumed to be assured if the buyer meets the initial investment and continuing investment criteria discussed earlier under the ‘‘Full Accrual Method.’’ It could be difficult to establish that the sales price is collectible if the buyer is unable to meet those criteria.

5. The total aggregate sales amounts and costs for all the units can be reasonably determined.

Because the determination of the periodic profits to be recognized is based on the estimated aggregate sales proceeds and estimated total cost of the project, it is crucial that these two numbers can be reasonably estimated. If these numbers cannot be estimated, the percentage-of-completion method is not allowed.

Any condominium or time-share project that does not meet any of these criteria can record the deposits received from the buyer using the deposit method.

 

 

5. Cost Recovery Method

The cost recovery method is another method of profit recognition of real estate sale. This method can be used in either of these situations:

  • Real estate transactions where the initial investment criteria were not met and the cost of the property cannot be recovered in the event the buyer defaults.
  • Transaction where the unpaid balance of the sales price due to the seller from the buyer is subject to future subordination. A seller’s receivable is subject to subordination if it is being placed in a position lower than another party’s claim against the buyer.

 

The cost recovery method is also appropriate in transactions where the installment method is allowed; thus, either method can be used in a transaction that meets the criteria mentioned earlier under the ‘‘Installment Method.’’

Under the cost recovery method, no profit is recognized by the seller until the total payments by the buyer to the seller are sufficient to cover the seller’s cost basis on the property.

On the seller’s financial statements for the transaction period, the income statement should show the sales, the deferred gross profit, and the cost of the property sold; the balance sheet should show the receivables from the buyer net of the deferred gross profit.

 

Case Example

A property was sold for $1 million with a cost basis to the seller of $700,000 that qualifies to be accounted for under the cost recovery method. The journal entries at the time of sale would be:

[Debit]. Receivable from Buyer = $ 1,000,000
[Debit]. Deferred Gross Profit (contra to sales) = $ 300,000
[Credit]. Sales = $1,000,000
[Credit]. Deferred Assets (contrs to receivables) = $ 300,000

[Debit]. Cost of Sales = $ 700,000
[Credit]. Property = $ 700,000

 

The seller’s income statement will present the transaction as:

Sales                              = $ 1,000,000
Deferred Gross Profit     = $  (300,000)
Net Sales                       = $    700,000
Cost of Sales $              =     (700,000)
Net Income                   = $              0

 

The seller’s balance sheet would show:

Receivable from Buyer = $ 1,000,000
Deferred Assets           = $  (300,000)
Total Assets                = $    700,000

 

Therefore, future periodic payments made by the buyer will be recorded as a reduction of the receivables with a portion credited to interest income.

10 Most Used Revenue Recognitions Rules and Methods

Revenue Recognition Methods and RulesWhen considering revenue, the accountant typically assumes that there is only one point at which revenue is recognized, which is when the completed product or service is delivered to the customer. That is not totally wrong neither is completely correct. There are a number of rules regarding exactly when revenue can be recognized.

Through this post I will cover 10 revenue recognition methods, all of which can be used under specific circumstances, and few of which precisely conform to this accounting rule. Consequently, the accountant should be aware of which of the revenue recognition scenarios presented in this post are most applicable to his or her situation, and report revenues accordingly. Read on…

 

Revenue Presentation

Revenue is the inflow of funds or related accounts receivable or other assets from other business entities in exchange for the provision of products or services by a company. It may also include incidental revenues from financing activities, such as dividends, interest income, or rent, or through the sale of assets. However, gains and losses that have little to do with the ongoing activities of the corporation (such as through an asset sale) should not be combined with revenues garnered from standard operations, because this would improperly show revenues that do not reveal the scale of ongoing operations.

A gain or loss on a transaction that is essentially unrelated to a company’s ongoing operations should not be recorded as revenue at the top of the income statement, but rather as a separate line item below the results of continuing operations.

 

However, if the amount of the gain or loss is not material, it can be offset against other operating expenses and lumped into the results from continuing operations. The “Other Income” category on the income statement typically includes all revenues not directly associated with operations, and that do not include gains or losses on other transactions, as just noted. This category includes income from financing activities, such as dividends or interest income (unless this is a primary activity of the business, such as would be the case for a mutual fund or insurance company). It can also include any profits earned on the sale of those assets not normally offered for sale (typically fixed asset sales).

 

Revenue Recognition Rules

The accountant should not recognize revenue until it has been earned. There are a number of rules regarding exactly when revenue can be recognized, but the key point is that revenue occurs at the point when substantially all services and deliveries related to the sale transaction have been completed.

Within this broad requirement, here are a number of more precise rules regarding revenue recognition:

[1]. Recognition at point of delivery. One should recognize revenue when the product is delivered to the customer. For example, revenue is recognized in a retail store when a customer pays for a product and walks out of the store with it in hand. Alternatively, a manufacturer recognizes revenue when its products are placed on board a conveyance owned by a common carrier for delivery to a customer; however, this point of delivery can change if the company owns the method of conveyance, since the product is still under company control until it reaches the customer’s receiving dock.

[2]. Recognition when customer acceptance is secured. The Securities and Exchange Commission has become increasingly disturbed by the amount of abuse in the area of revenue recognition by public companies, and accordingly issued Staff Accounting Bulletin Number 101 in 1999 to tighten the rules under which revenues may be recognized. For example, if there is any uncertainty about customer acceptance after a product or service has been delivered, then revenue should not be recognized until acceptance occurs.

[3]. Recognition at time of payment. If payment by the customer is not assured, even after delivery of the product or service has been completed, then the most appropriate time to recognize revenue is upon receipt of cash. For example, if a book publisher issues new editions of books to the buyers of the last edition without any indication that they will accept the new shipments, then waiting for the receipt of cash is the most prudent approach to the recognition of revenue.

[4]. Other rules. In addition to the above rules, there are a few others that should be applicable in all instances:

  • The seller should have no obligation to assist the buyer in reselling the product to a third party; if this were the case, then the seller would have an outstanding obligation to assist in further sales, which would imply that the initial sale had not yet been completed.
  • Any damage to the product subsequent to the point of sale will have no impact on the buyer’s obligation to pay the seller for the full price of the product; if this were the case, one would reasonably assume that at least some portion of the sale price either includes a paid warranty that should be separated from the initial sale price and recognized at some later date, or that the sale cannot be recognized until the implied warranty period has been completed.
  • The buying and selling entities cannot be the same entity, or so closely related that the transaction might be construed as an inter-company sale; if this were the case, the inter-company sale would have to be eliminated from the financial statements of both the buyer and the seller for reporting purposes, since the presumption would be that the sale had not really occurred.

 

Next let’s go to the 10 most used revenue recognition method

 

Revenue Recognition Under The Cash Method

Revenue recognition under the cash method simply means that revenues are recognized at the point when cash is received from a customer that is in payment of a sale to that customer.  There is no difference between the accrual and cash methods if sales are over-the-counter, but there can be a significant difference if the majority of sales are billed to customers, for which payment is received at some later date. The cash basis of revenue recognition is not recognized as an acceptable reporting method by GAAP, since it does not match revenues to related expenses. Instead, the matching of revenues and expenses is entirely dependent upon the timing of cash receipts and expenses, which are subject to manipulation.

This method is acceptable to the Internal Revenue Service for tax reporting purposes, but only in a limited number of cases and for smaller companies.

 

Revenue Recognition Under The Accrual Method

The most common revenue recognition system is based on the accrual method. Under this approach, if the revenue recognition rules presented in the last section have been met, then revenue may be recognized in full. In addition, expenses related to that revenue, even if supplier invoices have not yet been received should be recognized and matched against the revenue. The name of this method does not imply that the revenue should be accrued—the name of this approach only applies to the accrual of expenses.

For example: If the Lie Dharma Putra Company sells a set of face masks for $500 and recognizes the revenue at the point of shipment, then it must also recognize at the same time the $325 cost of those masks, even if it has not yet received a billing from the supplier that sold it the masks. In the absence of the billing, the cost can be accrued based on a purchase order value, market value, or supplier price list.

 

Revenue Recognition Under The Installment Sales Method

The installment method is used when there is a long string of expected payments from a customer that are related to a sale, and for which the level of collectibility of individual payments cannot be reasonably estimated. This approach is particularly applicable in the case of multi-year payments by a customer. Under this approach, revenue is recognized only in the amount of each cash receipt, and for as long as cash is received. Expenses can be proportionally recognized to match the amount of each cash receipt, creating a small profit or loss at the time of each receipt.

An alternative approach, called the “cost recovery method” uses the same revenue recognition criterion as the installment sales method, but the amount of revenue recognized is exactly offset by the cost of the product or service until all related costs have been recognized; all remaining revenues then have no offsetting cost, which effectively pushes all profit recognition out until near the end of the installment sale contract.

 

Revenue Recognition Under The Completed Contract Method

In the construction industry, one option for revenue recognition is to wait until a construction project has been completed in all respects before recognizing any related revenue. This method makes the most sense when the costs and revenues associated with a project cannot be reasonably tracked, or when there is some uncertainty regarding either the addition of costs to the project or the receipt of payments from the customer.

However, this approach does not reveal the earning of any revenue on the financial statements of a construction company until its projects are substantially complete, which gives the reader of its financial statements very poor information about its ability to generate a continuing stream of revenues. Consequently, the percentage of completion method (see next section) is to be preferred when costs and revenues can be reasonably estimated.

 

Revenue Recognition Under The Percentage Of Completion Method

This method is most commonly used in the construction industry, where very long-term construction projects would otherwise keep a company from revealing any revenues or expenses on its financial statements until its projects are completed, which might occur only at long intervals.

Under the percentage of completion method, the accountant develops a percentage of project completion based on the total costs incurred as a percentage of the estimated total cost of the project, and multiplies this percentage by the total revenue to be earned under the contract (even if the revenue has not yet been billed to the customer). The resulting amount is recognized as revenue. The gross profit associated with the project is proportionally recognized at the same time that revenue is recognized.

The trouble with this method is that one must have good cost tracking and project planning systems in order to ensure that all related costs are being properly accumulated for each project, and that cost overruns are accounted for when deriving the percentage of completion.

For example: If poor management results in a doubling of the costs incurred at the half-way point of a construction project, from $5,000 up to $10,000, this means that the total estimated cost for the entire project (of $10,000) would already have been reached when half of the project had not yet been completed. In such a case, one should review the remaining costs left to be incurred and change this estimate to ensure that the resulting percentage of completion is accurate.

 

If the percentage of completion calculation appears to be suspect when based on costs incurred, one can also use a percentage of completion that is based on a Gantt chart or some other planning tool that reveals how much of the project has actually been completed.

For example: if a Microsoft Project plan reveals that a construction project has reached the 60% milestone, then one can reasonably assume that 60% of the project has been completed, even if the proportion of costs incurred may result in a different calculation.

 

If the estimate of costs left to be incurred, plus actual costs already incurred, exceeds the total revenue to be expected from a contract, then the full amount of the difference should be recognized in the current period as a loss, and presented on the balance sheet as a current liability.

 

Revenue Recognition Under The Proportional Performance Method

This method is only applicable to service sales. It is used when a number of specific and clearly identifiable actions are taken as part of an overall service to a customer. Rather than waiting until all services have been performed to recognize any revenue, this approach allows one to proportionally recognize revenue as each individual action is completed. The amount of revenue recognized is based on the proportional amount of direct costs incurred for each action to the estimated total amount of direct costs required to complete the entire service.

For example: If a service contract for $100,000 involved the completion of a single step that required $8,000 of direct costs to complete, and the total direct cost estimate for the entire job were $52,000, then the amount of revenue that could be recognized at the completion of that one action would be $15,385 ( ($8,000/$52,000) x $100,000).

 

Revenue Recognition Under The Production Method

It is generally not allowable to record inventory at market prices at the time when production has been completed. However, this is allowed in the few cases where the item produced is a commodity, has a ready market, and can be easily sold at the market price.

Examples of such items are gold, silver, and wheat. In these cases, the producer can mark up the cost of the item to the market rate at the point when production has been completed. However, this amount must then be reduced by the estimated amount of any remaining selling costs, such as would be required to transport the commodity to market. In practice, most companies prefer to record the cost of commodities at cost, and recognize revenue at the point of sale. Consequently, this practice tends to be limited to those companies that produce commodities, but which have difficulty in calculating an internal cost at which they can record the cost of their production (and so are forced to use the market price instead).

 

Revenue Recognition Under The Deposit Method

When property is sold on a conditional basis, whereby the buyer has the right to cancel the contract and receive a refund up until a pre-specified date, the seller cannot recognize any revenue until the date when cancellation is no longer allowed. Until that time, all funds are recorded as a deposit liability. If only portions of the contract can be canceled by the buyer, then revenue can be recognized at once by the seller for just those portions that are not subject to cancellation.

 

Revenue Recognition Under Bill And Hold Transactions

When a company is striving to reach difficult revenue goals, it will sometimes resort to bill and hold transactions, under which it completes a product and bills the customer, but then stores the product rather than sending it to the customer (who may not want it yet).

Though there are a limited number of situations in which this treatment is legitimate (perhaps the customer has no storage space available), there have also been a number of cases in which bill and hold transactions have subsequently been proven to be a fraudulent method for recognizing revenue.

Consequently, the following rules must now be met before a bill and hold transaction will be considered valid:

  • Completion. The product that is being stored under the agreement must be ready for shipment. This means that the seller cannot have production staff in the storage area, making changes to the product subsequent to the billing date.
  • Delivery schedule. The products cannot be stored indefinitely. Instead, there must be a schedule in place for the eventual delivery of the goods to the customer.
  • Documentation. The buyer must have signed a document in advance that clearly states that it is buying the products being stored by the seller.
  • Origination. The buyer must have requested that the bill and hold transaction be completed, and have a good reason for doing so.
  • Ownership. The buyer must have taken on all risks of ownership, so that the seller is now simply the provider of storage space.
  • Performance. The terms of the sales agreement must not state that there are  any unfulfilled obligations on the part of the seller at the time when revenue is recognized.
  • Segregation. The products involved in the transaction must have been split away from all other inventory and stored separately. They must also not be made available for the filling of orders from other customers.

 

Revenue Recognition For Brokered Transactions

Some companies that act as brokers will over-report their revenue by recognizing not just the commission they earn on brokered sales, but also the revenue earned by their clients.

For example: If a brokered transaction for an airline ticket involves a $1,000 ticket and a $20 brokerage fee, the company will claim that it has earned revenue of $1,000, rather than the $20 commission.

 

This results in the appearance of enormous revenue (albeit with very small gross margins), which can be quite misleading.

Consequently, one should apply the following rules to see if the full amount of brokered sales can be recognized as revenue:

  • Principal. The broker must act as the principal who is originating the transaction.
  • Risks. The broker must take on the risks of ownership, such as bearing the risk of loss on product delivery, returns, and bad debts from customers.
  • Title. The broker must obtain title to the product being sold at some point during the sale transaction.

 

Revenue Recognition for Accretion And Appreciation

Some company assets will grow in quantity over time, such as the timber stands owned by a lumber company. A case could be made that this accretion is a form of revenue, against which some company costs can be charged that are related to the accretion.

However, this accretion in value is not one that can be recognized in a company’s financial reports. The reason is that no sale transaction has occurred that shifts ownership in the asset to a buyer.
Some company assets, such as property or investments, will appreciate in value over time. Once again, a case could be made that the financial statements should reflect this increase in value. However, as was the case with accretion, accounting rules do not allow one to record revenue from appreciation in advance of a sale transaction that shifts the asset to a buyer.

For both accretion and appreciation, it is not allowable to record an unrealized gain in the financial statements; instead, the gain can only appear at the time of a sale transaction. The current accounting treatment tends to understate a company’s assets, since it restricts the recorded valuation to the original purchase price; however, the use of estimates to reflect increases in asset value could be so easily skewed by corporate officers striving to improve reported level of profitability or company valuation that there would not necessarily be any improvement in the accuracy of reported information if the accretion or appreciation methods were to be used.

 

Revenue Recognition For Initiation Fees

A company may charge an initiation fee as part of a service contract, such as the up-front fee that many health clubs charge to new members. This fee should only be recognized immediately as revenue if there is a discernible value associated with it that can be separated from the services provided from ongoing fees that may be charged at a later date.

For example: if a health club initiation fee allowed a new member access to the swimming pool area, which would not otherwise be available to another member who did not pay the fee, then this could be recognized as revenue. However, if the initiation fee does not yield any specific value to the purchaser, then revenue from it can only be recognized over the term of the agreement to which the fee is attached. For example, if a health club membership agreement were to last for two years, then the revenue associated with the initiation fee should be spread over two years.

 

Despite the large number of revenue recognition scenarios presented in this post, the accountant will probably only use the accrual method in most situations. The other revenue recognition methods noted here are designed to fit into niche situations in which the circumstances of an industry require other solutions to be found.